Starbucks Goes Down Hard to Mondelez in Grocery War

NEW YORK(TheStreet) -- Even for Starbucks (SBUX) $2.76 billion is a chunk of change.

That's how much an arbitrator has said the company must pay for canceling a contract with Kraft Foods (KRFT) for packaged coffee sold in grocery stores.

Starbucks will pay that money to Mondelez International (MDLZ), which kept Kraft's global snacking and food brands but in 2012 spun off the North American grocery manufacturing business into the new Kraft Foods.

The price may be bigger than a venti Caramel Macchiato, but Starbucks may still consider it a bargain. Let's go through the whole tale and see if you don't agree.

Over the last four years Starbucks has made a major move into the grocery aisle, offering instant coffee, single-serving K-Cups, and energy drinks. The company's executives have said they want packaged goods to make up half of Starbuck's sales, which were nearly $15 billion last year.

Getting control of that channel, and of its brand, is a key to Starbucks' growth strategy. Wall Street is a big believer in that strategy and recently was valuing Starbucks with a price-to-earnings ratio of more than 35.

Starbucks first talked publicly about canceling the deal in early 2010, a year after launching the VIA line of instant coffee, which drew strong reviews and $100 million in sales.

When Starbucks finally canceled Kraft, in March 2011, Kraft said the new deal was perpetual, automatically renewable, and that it had grown the company's grocery business from $50 million in 1998 to $500 million. It demanded fair market value for that business, plus a premium of 35%.

Starbucks had been moving against the deal for months by then, with Kraft claiming Starbucks had offered $750 million to end the contract, a figure Kraft called inadequate. Starbucks alleged the contract had been breached as early as October 2010, claiming $100 million in lost sales.

The arbitration award is far richer than that original offer. It's $2.23 billion in damages plus $527 million in interest and attorney fees.

Starbucks has enough cash and borrowing capacity to pay, and says it will book the cost to its 2013 fiscal year. As of the end of September, Starbucks had $2.58 billion in cash and equivalents on its books, and another $658 million in short-term investments.

The company recently doubled long-term debt to almost $1.3 billion to reach that cash figure. If it borrowed to pay off Mondelez it could temporarily raise debt to more than 35% of assets. Paying in cash would wipe out its cash position.

Regardless of how Starbucks finances this, it's going to be a major hit to the balance sheet. Fortunately, the company threw off $3 billion in operating cash flow during the last quarter, and more than $3 billion more during the first half of the year. Paying the award isn't the issue. The cost to Starbucks' growth after paying the award is the issue.

For Mondelez, meanwhile, this is a windfall. The company reported revenue of almost $8.6 billion for the quarter ending in June, but only $616 million in profit. Mondelez has a market cap of $57.75 billion, almost as much as Starbucks' $60.72 billion, and says it will use the money to buy back stock.

At the time of publication, Blankenhorn had no positions in stocks mentioned.